Over the last 3 months we’ve discussed the first three “C’s” that are used by lenders to assess all loan applications, being Character, Collateral and Capacity. In this issue of the Trilogy Report, we consider the fourth and final “C” – Capital.
As the term suggests, “capital” is all about how much you are able to contribute to the transaction. In other words, how much cash are you chipping in as a deposit? Capital is the bank’s barometer that helps them to assess how committed you actually are to the deal and as such, it speaks volumes in your application.
For instance, are you seeking 100% finance or are you only asking for 60%? Now, picture yourself as the credit officer; are you more likely to approve a loan at 60% or 100% of the asset’s total value?
As you are probably already aware, the lower the level of funding sought (what we call the Loan to Value Ratio or LVR for short), the less risk the lender is taking, as a higher degree of risk is transferred to the borrower.
This is essentially due to the fact that if you default on your loan and fail to make the repayments, forcing the bank to sell off the asset, the bank risks losing less of their funds if a larger deposit (or a higher proportion of capital) is offered by you at the outset.
In other words if you pay a 40% deposit and the bank provides you with the balance of 60%, while you will lose your contribution in its entirety, the bank only has to recoup 60% of the original sale price of the asset in order to break even and recover their funds. Hence, a larger deposit and therefore a smaller LVR makes your loan application more appealing, as the banks have greater peace of mind in knowing that should things go pear shaped, their money is more likely to be safe.
What you, as the borrower, need to realise is that Capital is effectively the lynch pin of your deal and depending on the size of your deposit, can make or break your loan application. Basically, a substantial deposit can pretty much get any loan over the line.
I once heard someone say, “You can insure a burning house for the right premium” and essentially, the same applies to getting the nod from your lender; you can virtually get any loan approved with the right amount of deposit or Capital.
So let’s have a look at some examples of how Capital can sway the banks in your favour, even though your application may be lacking when it comes to any of the other three “C’s”…
Assuming your loan application is light on Character (you might have defaults on your credit report, be new to the country, have slow credit accounts, etc). An offer of more upfront Capital can override these glitches and persuade the bank to say yes. This is because you are reassuring them that although you may have made some mistakes with credit in the past, or they may not be certain as to your commitment to the deal, your contribution of a larger deposit is proof that you are indeed a “safe bet”.
What if your application is supported by security (Collateral) that will be difficult for the lender to sell in the event of a foreclosure? It could be a retail shop front in a street that has a high level of vacancies or a block of 6 units in a small country town for instance. From the lender’s perspective, both of these scenarios carry a higher level of risk than normal residential housing in the suburbs. They might look at that collateral unfavourably because if they are forced to sell and recoup their debt, they could have trouble finding a buyer willing to pay the necessary price.
In this situation, the lender will ask you to assume more risk and contribute more cash (AKA “hurt money” or “skin in the deal” for obvious reasons), thereby lowering the LVR and reducing their risk. By failing to provide the extra cash, you are essentially sending a message to the lender that you are not as committed to the whole transaction as you expect them to be.
In recent times, many property investors were unable to provide evidence of Capacity in the conventional way; in other words, they could not necessarily assure the banks that they could meet the required repayments for the amount they were seeking.
This may have been due to the fact that a large portion of their income consisted of cash, or they were behind in their tax returns. In this situation, the lender would ask the borrower to increase the deposit on their application to assume more risk and in turn, they would overlook this Capacity shortfall.
They would offer the applicant a “Low Doc loan” and although these still exist to some degree today, the banks now require extra evidence in order to get them across the line. They have also reduced their exposure to them by forcing the borrower to contribute more cash to the deal; hence lowering the LVR “just in case” the borrower cannot meet the repayments.
Now throughout these last few paragraphs I’ve been using the terms “cash” or “deposit” when discussing the possibility of reducing the LVR to entice the lender into approving your loan application. What I have failed to mention however, is that this money can actually be borrowed from another source or against other security. This means you can still gear at a higher level, say 100% or even 106% to cover all costs; it just might mean you have to approach two different lenders to secure funding.
Let’s look at an example of how you might do this if you decided to purchase a retail shop front for $600,000;
In Diagram 1, we are contributing the deposit and closing costs using our “saved up cash”.
In Diagram 2, we buy the same property but pull the deposit from another property that has a Line of Credit against it and is possibly held with another bank.
As you can see, the lender is happy with a reduced LVR at 70% and the borrower wins too as they essentially managed to secure106% funding.
Of course there are some industry standards applicants must meet when it comes to the amount of deposit required to buy a property. Here’s a bit of a guide as to how much deposit lenders will ask for on individual securities, assuming the applicant’s Character, Collateral and Capacity are favourable.
Keep in mind as you read through the following that your closing costs, such as legal’s, rates adjustments and stamp duties, are payable in addition to the deposit. As a guide, approximately 6% of the property’s purchase price is usually ample to meet all of these and in some states you’ll need a bit less. It goes without saying that you should cross check all associated purchase costs before you buy. Now, back to the required deposit amount for various securities…
- Residential houses in the suburbs – 20% to as low as 5%, depending on whether or not you want to incur a lender’s mortgage insurance fee.
- Block of 6 units on single title – Typically 40% is needed, but some lenders will go as low as 30%.
- Commercial property such as a retail shop – same as per a block of units in the above example.
With the understanding that Capital is effectively the make or break aspect of your loan application, you have the capacity to buy any property you like – as long as you are prepared to save the necessary deposit to get the bank’s nod of approval. In other words, the property you can buy will only be restricted by the amount of deposit you are able to contribute.
As a rule of thumb, a smaller deposit paid to the lender usually equates to a higher interest rate and additional fees. It is very much user pay and remember – there are no free lunches when it comes to the banks!
As mentioned in my intro and the feature article on mortgage managers, the NAB has recently announced it’s acquisition of James Packer’s Challenger (now known as Advantedge) and made a commitment to fund mortgage managers without the need for securitisation, meaning increased competition in the lending industry and more options for borrowers.
Mortgage managers are finance specialists who organise funding for property investors and home buyers from numerous sources. Their role is to not only arrange the necessary funds for your property loan, but also manage and administer your loan for its duration, from credit assessment right through to monitoring your repayments, applicable insurance and renewals, interest rate adjustments and any variations for the life of the loan.